Liquidate or liquefy?

Is the title of this article by Daniel Gros.

He says Europe has chosen ‘liquefaction’ over liquidation. It has preferred to continue to pump liquidity in its banking systenm helping them survive. However, liquidation or celaning up the system is as important:

Europe has clearly chosen ‘liquefaction’ over liquidation. However, unlimited ‘liquefaction’ has its disadvantages.  First of all it is obviously not a solution for insolvent debtors; it just delays the day of reckoning. Secondly, it is addictive. Recourse to the ECB will remain by far the cheapest source of funds for banks in the Euro periphery. They will thus try to increase their recourse to ECB funding all the time, with the result that the risk on the balance sheet of the ECB will be increasing. This is why the ECB had to tighten recently its eligibility criteria for the collateral it accepts as banks in the periphery, and some weak banks in core euro states, had obviously a tendency to transform ever more risky parts of their assets into securities that they could use as collateral for the ECB’s windows. This illustrates a further problem: Political instances have to take over the function of capital markets. The ECB and the EFSF now decide which countries and banks have access to funding and at what cost. Representatives of the ECB have rightly pointed out that the capital market had made a fundamental mistake in funding Greece for too long at excessively low risk premia and that the market and the ratings agencies might now err in the opposite direction by overestimating the risk of insolvency. But who can guarantee that the ECB is right to lend 40% of GDP at a zero risk premium?

Is there an alternative between indiscriminate liquidation and continuing liquefaction? The obvious way out should be controlled rescheduling and/or restructuring in order to avoid turning parts of the euro periphery into ‘zombie countries’. The problem is that in an environment of essentially free money no debtor will ever appear insolvent and admit to it. No debtor will thus have an interest to engage in a restructuring or rescheduling as long as interest rates remain close to zero and liquidity is available without limits. A ‘Japanese’ scenario in which financial markets cease to function properly is thus becoming ever more likely for Europe as well.

The same problem applies to US as well. Hardly anything has happened cleaning up the financial system there.

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